March 4, 2003 (PLANSPONSOR.com) - An Arizona
appellate court says that the state is illegally taxing
federal workers on contributions to their pension plans - and
has been doing so for more than a decade.

In a decision published last Friday, the Arizona Court
of Appeals noted that Arizona law is structured so that
while state and local workers pay no income tax on the
portion they are required to contribute to government
retirement plans, federal workers – some 40,000 of them –
have not been accorded the same favorable treatment,
according to the Arizona Tribune.

And if the request for class action is approved, the
state could be looking at repayments of about $100 million,
covering taxes paid since 1990.

When state and local government workers make mandatory
contributions to their retirement systems, those
contributions are made on a pre-tax basis, much as most
401(k) salary deferrals are handled.
However, there is no similar system for most other workers
in Arizona, according to the report.

Case History

According to the Arizona Department of Revenue, in 1994
the Arizona Court of Appeals held that the state’s
statutory scheme was unconstitutional because it violated
the intergovernmental tax immunity doctrine, which bars
states from discriminating in how they tax federal
employees.
In response, the DOR offered federal workers in the state
the option to subtract those contributions from Arizona
taxable income, but warned that if the DOR prevailed in its
action, they could be subject to potential audit (see
http://www.revenue.state.az.us/taxnews/0303news.pdf
).

However, in the recent ruling, Judge Cecil Patterson Jr.
wrote for a unanimous court in noting, “Arizona has chosen
to design its individual income taxing scheme in a way that
includes federal employees’ mandatory retirement
contributions in their Arizona gross incomes, but excludes
from Arizona gross income the corresponding mandatory
retirement contributions of state and local employees.”